A LEADING adviser has written to unit trust groups urging them not to deal with secretive hedge fund companies. The moves come amid fears that small savers in the UK could be disadvantaged by the activities of those hedge funds that buy and sell stakes in unit trusts.

Allenbridge, a specialist in fund analysis, issued its plea after growing increasingly alarmed by the “market- timing” strategies deployed by some hedge funds. Hedge funds have different aims, some acting to protect the capital of their wealthy clients, while others promise above- average returns.

By moving large amounts of money in and out of unit trusts, hedge funds can exploit minute mispricings. The practice is not illegal, but it is widely regarded as unethical because it harms the interests of long-term unit-holders by reducing their total returns.

Anthony Yadgaroff, the managing director of Allenbridge, says in a letter to top unit trust groups that the practice of market-timing raises issues of conflict of interest. “If we cannot get an assurance that you will not allow this, we will remove your funds from our buy list,” he says.

The warnings to unit trust groups come against the background of the latest scandal to hit Wall Street. Eliot Spitzer, the New York attorney-general, led an investigation which found that mutual funds and hedge funds there had colluded illegally, to the detriment of small investors.

One firm, Canary Capital Partners, a hedge fund that Mr Spitzer said committed illegal trades involving funds operated by a number of banks, agreed to a $40 million settlement. While there is no suggestion that hedge funds in the UK are engaged in unlawful practices, their role is still a matter for concern.

There are many hedge fund companies operating in the UK, but Pentagon Capital Management has attracted the attention of the financial community after making returns of up to 37 per cent for its high-net worth clients. Its strategy is based on market-timing dealings.

Even by hedge industry standards, Pentagon’s activities are extremely opaque. Most of its clients are recruited through word of mouth. Pentagon’s chief executive and founder, Lewis Chester, 35, a graduate of Oxford and Harvard, runs the company with another director and his father. Although the company is due to file its 2002 accounts on October 31, after negotiating a three-month extension, the trio is rumoured to have netted tens of millions of pounds in profits last year.

It is thought that Pentagon manages to avoid hefty dealing costs itself by agreeing a sizeable annual management fee with the asset managers, which would allow the firm to trade in and out of the funds as often as it liked.

But now several large asset management companies, including Invesco, Schroders and Fidelity, say that they no longer deal with Pentagon. Others, such as Legal & General, would not confirm or deny any dealings with the firm. The London office of DWS Investments, the mutual fund arm of Deutsche Bank, says that it will impose punitive charges on hedge funds dipping in and out of its funds.

One fund manager, who did not want to be named, says: “We don’t want to deal with market timers, we want long- term investors. These firms cost the fund a lot of money in dealing costs, which destroys value for long-term investors.”

The managing director of another fund management company that also claims to have severed ties with Pentagon says that the firm had placed a few million pounds in one of its funds this year. But within days Pentagon sold its units as the markets rose.

He explains that while this practice is legal, it has a detrimental effect on smaller investors. Each time someone invests in the fund, the asset manager must buy the underlying shares on the stock market, and the fund incurs the transaction costs. When the client sells, a similar process occurs.

“If this happens only occasionally, the costs to other investors are incidental,” the fund manager says. “But if it goes on a few times a week, they could be significant.”

Market timers also make money by exploiting the fact that most companies price their funds only once a day. By watching what the world markets do after a price has been set, market timers can buy a fund — which is meant to be a long-term investment — at a historic price. When the fund is repriced, they immediately sell at a profit.

Richard Saunders, chief executive of the Investment Management Association, says: “If someone can exploit price inefficiencies in a fund, it is generally the other investors who lose out.

“There is nothing illegal about this, but fund managers are perfectly within their rights to turn people away if they damage other investors.”

Pentagon, which is thought to have nearly a billion pounds under management, says that its activities are perfectly legal and that it has always submitted quarterly reports to the Financial Services Authority. It appointed PricewaterhouseCoopers, the accountancy firm, to review its trading practices and report to the FSA. The FSA this week declined to comment on whether it was looking into the company’s activities.